This post has been contributed by guest author Milan Jha, with assistance from Fintuned editorial team.
Three years back when Raghuram Govinda Rajan took the divine but immensely challenging role of RBI’s governor, he was hailed as the poster boy of Banking, the sexiest figure in Banking among other such sizzling titles. As a matter of fact, this article by Shobhaa De back in 2013 clearly highlighted the eye-catching attractiveness of our deserving RBI governor. Tales aside, Raghuram Rajan has been successful in exceeding expectations of stakeholders. As with any central bank, Raghuram has achieved this stellar performance by making use of his magic wand.
Whether it’s the sheer charm possessed by Raghuram or something else, I have realized that increasingly people have started keeping a tab on the monetary policy announcements by Dr. Rajan (at least, I know that I do :P). As such it is imperative that we decode the significance of monetary policy and more than anything else, know of its significance on our daily lives. In this article therefore, staying true to the writing principles followed by Fintuned (just written to entertain the site owners :P), I have tried to bring out the salient aspects about monetary policy in general.
To begin with, monetary policy is the process by which monetary authority of a country, generally a central bank controls the supply of money in the economy by its control over interest rates in order to maintain price stability and achieve high economic growth.
How does monetary policy affect me?
As I highlighted above, understanding monetary policy’s significance is of paramount importance for everyone. To be sure, let me go ahead and say that it is impossible to effect a sustainable wealth building exercise without having enough know-how about the monetary policy. So, here we go!
Open market operations:
The RBI uses this tool to buy or sell government securities from or to the public and banks. When the RBI has to restrict the availability of money to the market to curb inflation, it sells government securities to the banks and public. By doing so, the money flows from the market to the reserves of RBI and is not available to the banks or the public for investment and consumption.
Similarly, when the RBI has to increase the availability of money to the market, it buys government securities from the banks and public. Owing to increased investment and consumption, economic growth gets a boost and inflation increases as well. The effect is increase in commodity prices and a probable increase in job opportunities.
Bank rate and repo rate policies:
Both of these are rates of interest at which the RBI charges for providing funds to the commercial banks.
The banks rate is the interest rate on the loans provided for long-term without any collateral to the commercial bank.
The repo rate is the interest rate at which RBI lends to commercial banks generally against government securities. The repo rate is applicable on short-term loans given to the commercial banks and requires collateral. The repo rate after the 0.25 percent cut on 5th April, 2016 stands at 6.50 %.
If any of these rates is increased by the RBI, it discourages the commercial banks from borrowing money due to higher cost of borrowing. This in turn, reduces the availability of money with the commercial banks that it could lend to the public. So the commercial banks also increase their lending rates which make all types of loans expensive discouraging the public to from borrowing from banks. Since they borrow less, they use less of their money causing inflation to decrease. The effect is slow growth of commodity prices but also a reduction in job opportunities. The effect of decrease in any of these rates just causes an opposite effect, in theory at least.
*CPI = Inflation
The cash reserve ratio (CRR) and the statutory liquidity ratio (CRR):
Cash Reserve Ratio (CRR) is the minimum fraction of the net demand (example, savings account) and time deposits (example, fixed deposit for 5 years), which commercial banks have to hold as reserves either in cash or as deposits with the RBI. The current CRR is 4 %.
A higher CRR leaves less of cash with the commercial banks which results in an increase in the lending rates. As a result, all types of loans get expensive making people borrow less and thus invest and consume less money. This results in the slowing of the economic growth, a decrease in inflation and a decrease in employment growth as well. Thus, if CRR increases, loans get expensive and the growth in commodity prices slows down. Quite like other tools, the effect of a decrease is quite naturally, the opposite.
Every financial institution has to maintain a certain quantity of liquid assets with themselves at any point of time of their total time and demand liabilities (examples cited above). These assets have to be kept in non-cash form such as government securities, precious metals, approved securities like bonds etc. The ratio of the liquid assets to time and demand assets is termed as the statutory liquidity ratio. The SLR has been last reduced by 0.25percent on 5th April, 2016 to 21.25 % of Net Demand and Time Liabilities.
The effect of change in SLR is almost similar to that in CRR. This is because both of them affect the liquidity of the commercial banks in a similar manner.
Lastly, in all the cases where the public can borrow cheaply, the interest one gets by depositing money in a savings, fixed deposit or any other bank account also goes down. The expected low returns make the public pull out the money from bank deposits and invest in high yielding instruments like equities, long-term debt funds and tax-free bonds. That’s why we see the stock market rally whenever these rates are cut.